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Public Policy for Growth and Poverty Reduction

Nicholas Stern*

Abstract: In this paper, I would like to outline an approach to public policy that is

focused on fighting poverty and is based on an understanding of growth and develop-

ment. Such a public policy requires answering two key questions. First, what are the

key determinants of a development that benefits poor people – or what has been la-

belled “pro-poor growth”? And second, we need to answer the policy question: how

can public action influence the key determinants we identify? In putting the questions

this way, we are setting ourselves the task of building a dynamic public economics – a

public economics of development. Given that development is the objective, this task will

require a better understanding of how to measure it. And we must also achieve a better

grasp of changes of behaviour in the process of development, since changing perspec-

tives and behaviour are usually an integral part of the development story. In laying out

our task of advancing a dynamic public economics, however, let me emphasise that we

should be building on – not overturning – past theory. In much of the work I will de-

scribe, the empirics seem to be ahead of theory. Thus one of my purposes is to highlight

some elements of an agenda for theoretical research. (JEL E6)

1 Introduction

1.1 Brief review

Let us begin with a brief review of the changing ideas and perspectives on

government and policy over the past 30 years. This will serve both to remind

ourselves of what we are building on, and to see how the issues may go be-

yond these ideas. A major contribution of the theories of the last 30 years has

been in deepening our understanding of the complementarity between states

and markets.

• The public economics characterised by Boiteux (1949; 1956) and Dia-

mond-Mirrlees (1971) embodied a recognition that the state did not have

the capability or information necessary to direct production. Diamond and

Mirrlees focused on production incentives for producers, both private and

* Chief Economist and Senior Vice President, World Bank.

The paper has benefited from discussions at the Berglas School of Economics at Tel Aviv Uni-versity. David Ellerman has contributed greatly to the preparation of this paper and I am verygrateful to him. For advice and guidance, I would like to thank Phillipe Aghion, Peter Dia-mond, Coralie Gevers, Karla Hoff, Joyce Msuya, Halsey Rogers, Scott Wallsten, and twoanonymous referees. Efraim Sadka and Manuel Trajtenberg gave very helpful comments; I amvery grateful to them.

at London School of econom

ics on September 9, 2013

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Nicholas Stern

6 CESifo Economic Studies, Vol. 49, 1/2003

public, together with prices and taxes facing consumers, and they exam-

ined mutually consistency and optimality.

• These theories (in particular, that of Mirrlees, 1971) provided an explicit

analysis of the trade-off between size and distribution of the cake in mod-

els of non-linear income taxation – and here again, at the heart of the

problem was the construction of optimal incentives where information is

limited and asymmetric.

• The theories provided an anatomy of market failure (we include here, of

course, Berglas' contributions).

Thus at the heart of all this work was the complementarity between the state

and markets. The questions were not in terms of “how much” of each, or even

the “balance” between the two, but rather how they combine.

These were, of course, insights from theory, but they have also been supported

by experience. If anything is clear from the experience of the economies in

Eastern Europe and the former Soviet Union in transition to a market econ-

omy, it is that markets need sound government.

1.2 From statics to dynamics in public economics

The insights sketched above represent real achievements of lasting value.

However, this theory does not determine the key drivers of ‘pro-poor growth’

– by which I mean growth in which poor people participate, both in its creation

and its rewards. These drivers are my main topic here: the investment climate,

and empowerment of and investment in poor people. This approach goes be-

yond size and distribution of the cake; it sees the issues of development and

poverty reduction in terms of (i) generating growth and (ii) enabling participa-

tion in growth. Both elements are essentially processes with history, dynamic

structure, and learning, rather than the one-shot events found in the static the-

ory. Thus the challenge of public policy becomes one of how to understand

and influence these processes.

Within this perspective, entrepreneurship is central. How, analytically, can we

bring entrepreneurship into the story? How can we usefully model and

strengthen the insights of the Austrian School (e.g., von Mises, Schumpeter,

Hayek, Kirzner), which from the early 20th

century recognized the centrality of

entrepreneurship in the market process? How can we construct policies that

create the conditions for entrepreneurship to flourish?

Entrepreneurship is about opportunities, risk, and return, but it is particularly

about perceptions, and about the ability and willingness to respond to opportu-




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CESifo Economic Studies, Vol. 49, 1/2003 7

nities by going beyond the routine and taking a step into the unknown. Theo-

ries about entrepreneurship should therefore include an examination of learn-

ing, beliefs, and expectations. It should also bring in role models. Who domi-

nates society? Is it the warriors, thieves, or predatory bureaucrats who success-

fully grab large parts of the pie and kill incentives? Or is it the entrepreneurs

who help make a bigger pie? The lessons of history, including that of the for-

mer Soviet Union and the Balkans, are clear: a society that is dominated by

conflict and plunder has little future. (Sadly, conflict is all too often associated

with plunder, as the causation goes both ways.) By contrast, a society that is

led by creativity generates hope and results.

As Schumpeter (1934) emphasised so clearly, a competitive rule-governed

environment is fundamental to the flowering of entrepreneurship. It has to be

possible to enter markets and to innovate and to gain the rewards to innova-

tion. Those working on development issues around the world surely see the

potential for entrepreneurship in all societies. Yet all too often, when not mis-

directed into rent-seeking and plunder, entrepreneurship is suppressed by ob-

stacles and hurdles erected, operated, and maintained by those in powerful

positions, both public and private. It is undermined by weak governance and

bureaucratic harassment – both organised and opportunistic. And it is fre-

quently thwarted and discouraged by organised crime.

For example, World Bank firm surveys comparing the investment climate for

manufacturing industries in China and Pakistan show that the typical Pakistani

firm needed 72 days to get its most recent telephone connection, compared to

17 in China. The average time to clear the latest shipment of goods through

customs was 18 days in the Pakistan sample, compared with nine in the China

sample. Pakistani firms report losing 6 percent of their output as a result of

power outages, compared to 2 percent in China. What emerges is a picture of

Pakistani firms facing a more bureaucratic environment with poorer govern-

ment services and infrastructure. Evidently many factors go into the overall

investment climate. But in the manufacturing industries that we covered, semi-

skilled wages are fairly similar in China and Pakistan. In an increasingly inte-

grated world, then, it is not surprising that there is a large amount of foreign

and domestic investment in the manufacturing sector in China, and virtually

none in Pakistan. In a type of Gresham's Law of entrepreneurship, “entrepre-

neurial” predators from the private and public sectors tend to drive out pro-

ductive entrepreneurship.

These notions are central to a broader examination of development. And they

warn us against imposing some standard blueprint – a mistake some made at

the outset of the transition from command to market economies in the region.

But this was not a mistake made by the Chinese as they embarked on and de-




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veloped their own transition from 1979. They moved step-by-step – experi-

menting, building on what went before, and finding their own way.

The analytical path ahead is not one Grand Unified Theory; instead, it will be a

combination of strong empirics and a battery of dynamic theories. Although

the two processes of fostering investment climate and the empowerment of,

and investing in, poor people are my main concern here, two further challenges

in developing more dynamic theories might be mentioned. Both challenges

illustrate the importance of searching for insights in a number of directions.

They have to do with behaviour (e.g., entrepreneurship), the meaning of wel-

fare, and overall objectives.

1.3 Understanding behaviour

Development, especially the enhancement of empowerment and entrepreneur-

ship, usually involves fundamental changes in perceptions, understanding, and

behaviours. For example, education is central, and it changes both under-

standing and behaviours. A move from rural to urban often involves profound

changes in perceptions. The role of women is fundamental to participation,

education, health, and most economic activities. Changes in the understanding

of both men and women are usually crucial for the greater participation of

women in the economy and society.

Traditionally in economics, we model the behaviour of an individual in terms

of optimisation for a given pattern of preferences and with fully specified con-

straints. We then base our analysis of individual welfare on the finding of out-

comes that are ranked higher in terms of the individuals' given preferences.

This is a powerful approach, and it has yielded real and enduring insights into

the economics of policy. But we must recognise that development economics

and societal change often involve fundamental changes in behaviour. Thus we

need to look more deeply into how behaviour develops, adapts, and changes.

Empirically, behaviour is not always well represented by the simple maximi-

sation of a fixed utility function in the face of fully understood budget con-

straints and prices. There are many important examples of great relevance for

development where this approach to individual behaviour can be seriously

misleading. First, individuals are not very good at understanding the informa-

tional nature of decisions, particularly those involving uncertainty. For exam-

ple, in advanced countries, those making decisions about insurance, pensions,

or investments will very often choose the option labelled as the default option

whichever of the options is so prescribed. There would be many similar exam-

ples concerning loans and savings for poor people in developing countries.

Second, addictive behaviour associated with alcohol, drugs, tobacco, and gam-




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bling pervades developing countries as well as developed countries. Third,

intense, dogmatic, and doctrinaire education systems, whether secular or re-

ligious, can have profoundly damaging effects on behaviour. Other systems,

both secular and religious, can instil behaviour and codes that help build strong

and creative societies and, in matters of health for example, can be life-saving.

Fourth, behaviour can change dramatically under extreme conditions; for ex-

ample, the Second World War in the UK transformed attitudes about the role

of women in the workforce as well as about the health service, education, and

social protection. Fifth, values can change from examples set by leadership.

Many would argue that individual behaviour in Russia deteriorated in the

1990s in part from the example of large-scale looting of the state by powerful

figures inside and outside public service. Standards in Indian public life were

probably corroded by Mrs. Gandhi’s funding of elections using the proceeds of

corruption in the 1970s. All these examples surely demonstrate the importance

of examining the determinants of behaviour, particularly in societies undergo-

ing profound structural and social change.1

In understanding behaviour, culture will often be central. One clear example

comes from a health centre and clinic that I visited in a small town, Paruro, in

a poor, largely rural, part of Peru. A local initiative made an effort to increase

the number of women from rural areas who attended the clinic for childbirth.

Local discussion and a review of earlier projects indicated that women from

remote rural areas were unwilling to leave their children for an extended pe-

riod, found the clinic cold, and were uncomfortable using formal Western

birthing positions. The project established a “waiting house” where women

nearing childbirth could be lodged and fed, with their children, in accommo-

dations close to the clinic; it also installed extra heating in the birthing room

and provided a bed that could serve as an alternative to the standard Western

“birthing table”. The result was a dramatic rise in medically attended birth and

a significant fall in mortality of both babies and mothers. These practices have

also been followed by many other health centres in rural areas in Peru with

similar results. This example demonstrates clearly how attention to cultural

issues can lead to great advances in fighting poverty – in this case on the health

dimensions – and in the general development effectiveness of projects and

programs. It shows also that successful experiments can spread or be “scaled

up” – a crucial step if we are to increase development effectiveness.

Let me caution that these examples should not lull us into a belief that we

could or should take up “cultural engineering”. But we should encourage cul-

tural awareness and innovative approaches to improvements and problem-

1 I am happy to note that since this lecture was given, a Nobel Prize in Economics was awardedto Daniel Kahneman “for having integrsated insights from psychological research into eco-nomic science, especially concerning human judgment and decision-making under uncer-tainty”.




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solving. And of special importance is the building of environments and cross-

learning capacity so that successful innovations can spread, as has often hap-

pened during China’s reform period.

It is now widely accepted that institutions, and the question of how to build

them, lie at the heart of the development process. However, these examples

concerning behaviour suggest that formal institutions are only a part, and often

a small part, of the story – they are often only the tip of the iceberg. Many re-

forms fail because they change only the formal laws above the waterline, while

having little effect on the behaviour, norms, and attitudes which lie below the

surface.

1.4 Broadening the objectives of public policy

The second challenge follows in part from this discussion of changing behav-

iour. If the preferences that drive behaviour are endogenous, then the approach

of traditional public economics is undermined – for we cannot simply take the

preferences that people express through their current behaviour as an unambi-

guous basis for assessing their welfare. This simple preference-welfare ap-

proach is further complicated if we ask whether people’s welfare is, in any

case, correctly seen only in utility or preference terms. Amartya Sen, in his

book Development as Freedom, has argued that development is about the ex-

pansion of capabilities, or in one sense, expanding the ability of an individual

to shape his or her life. At the same time, however, this broadening in the di-

rection of capabilities or freedom can reduce the difficulty associated with en-

dogenous preferences, in the sense that it plays down the role of preferences in

assessing welfare changes. These broader perspectives take us way beyond

spending power in thinking of the objectives of development. They point to the

importance of ensuring that people have greater power over the decisions that

most affect them. And they point further to the importance of increasing secu-

rity. The challenge is to build these other objectives into more formal analyses

of poverty and public objectives.

Let me now put these two future challenges to one side, however, and elabo-

rate on the central set of issues that are my focus here. The issues concern the

analysis of the twin and intertwined processes of (i) improving the investment

climate and (ii) empowering and investing in poor people. In focusing on these

two processes as key drivers of pro-poor growth, please note that we are not

talking about steady states, about being on a production frontier, or about

comparisons of two equilibria. We are talking about processes of change, ad-

aptation, creativity, and learning.




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2 Building an investment climate for growth and opportunity

Growth depends on entrepreneurship, and entrepreneurship depends on the

climate surrounding ordinary business activity for farms, small firms, larger

firms, and foreign firms. Macroeconomic instability, bureaucratic harassment,

and failing infrastructure can strangle initiative, and they tend to hit small

firms and farms hardest. Thus, the central public policy question here is: “How

can countries develop governance and institutions to support entrepreneurship

and well-functioning markets − or, in other words, how can it build an invest-

ment climate that will generate growth and development?“

2.1 The investment climate and the role of public economics

The policy challenge is thus to promote growth through improvements in the

investment climate; it is about creating conditions so that the pie keeps ex-

panding. It is not just a question of how to avoid or limit losing slices of the

pie, as measured by Dupuit-Harberger triangles or even ‘rent-seeking quadri-

laterals’ – which are, crudely speaking, the type of losses which lie behind

standard trade-offs between size and distribution of the cake in basic static

public economics.

The investment climate notion forces us to look at government through the

eyes of the private sector – first and foremost, small entrepreneurs and farmers.

And we must always remember that the most important small and medium

enterprises (SMEs) in many developing countries are usually the farms. In

focusing on SMEs, we are not neglecting or forgetting entrepreneurship else-

where. Policy and institutional reforms that improve the climate for SMEs will

usually also improve the climate for large and foreign enterprises.

One important source of enterpreneurship is in break-aways from large (seed-

bed) firms by teams that pursue new products and new markets outside the

strategic focus of the large firms. This hive-off route to entrepreneurship and

new SMEs is particularly important where the business environment is as yet

rather inhospitable to the isolated entrepreneur. It is a key policy challenge to

devise ways to partially internalise the social gains from this positive external-

ity so that large seed-bed firms will not only tolerate but promote the process.

The general policy rule is to pay close attention to how entrepreneurial

“juices” are flowing in a particular institutional setting and then try to break

the barriers and widen the channels for the more productive flows.

For growth to happen, entrepreneurs need to be able to recognise and create

opportunities to increase productivity and make productive investments. And

they need an environment where they can pursue those opportunities effec-




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tively. Thus we need to think of a dynamic model of their behaviour built

around: (i) the constraints on their entrepreneurship; (ii) their ability to recog-

nise and create opportunity; and (iii) their learning processes. It is, of course,

about risk and return, but what we are trying to understand here is not only the

determinants of risk and return but also the determinants of entrepreneurs’ per-

ceptions and their ability to respond. The normative theory of the relevant

public policy will have to be based on positive models of the investment cli-

mate and the processes that change it.

Ideally, a clear structural theory of the investment climate would lead us di-

rectly to a definition of appropriate indicators for its measurement. I suspect

that a careful examination of more modern growth theory in the Schumpeterian

spirit has much to offer – see, for example, Aghion and Howitt (1997). At pre-

sent, however, we offer a pragmatic definition and approach for the investment

climate, one that is based on the intuitive notion described above and on the

responses of firms surveyed about barriers to entrepreneurship.

The investment climate can be analysed in terms of several broad sets of vari-

ables.

• Macroeconomic and trade policy. The importance of macroeconomic sta-

bility and of the openness of trade to entrepreneurship and investment is

increasingly regarded as obvious. And policies on these dimensions have

improved greatly in developing countries in the last two decades. Impor-

tant as these issues are, however, they are only part of the story, and it is a

fundamental mistake to believe that they constitute the whole story. The

deeper problems with the investment climate are structural and concern

governance, institutions, and infrastructure.

• Governance and institutions. The ability of firms to pursue innovations

and investments is profoundly influenced by governance and institutions.

Governance is not an elegant word and is often used loosely. However, the

definition given by the Oxford English Dictionary – “the manner of gov-

erning” – is helpful in that it leads directly to a focus on the behaviour of

those who are governing and who are in public service. Bureaucratic har-

assment is a fundamental constraint on and discouragement to entrepre-

neurship. So too are crime (organised and otherwise) and lawlessness. The

absence of well-functioning legal and regulatory institutions can under-

mine or suppress entrepreneurial activity; so too can weak financial insti-

tutions. The functioning of a whole range of institutions, including those

that shape labour relations and skills, can have a profound effect on the

ability to pursue creative and productive activity.

• Infrastructure. Weakness of the infrastructure is often the first obstacle to

entrepreneurship that firms identify. Power outages and variable voltage




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can frustrate economic activity, for example, and it is difficult to build

businesses without telephones and water supply. Problems in the infra-

structure can arise for various reasons, but they are often associated with

weak governance. Whatever their source, they can be very destructive of

innovation and productive activity.

2.2 The investment climate: identifying the obstacles

Good public economics depends on good empirical information and analysis.

These, in turn, should be related to theory. The basic theory of public eco-

nomics, which advanced strongly in the 1970s, focused on the structure of in-

dividual or household demand and on aggregate supply and demand functions.

Accordingly, applied work centred on household surveys and the structure and

estimation of supply and demand functions. Similarly, empirical work to in-

form public policy from the perspective of the investment climate should help

to understand the problems along the dimensions just described. The identifi-

cation of obstacles to investment and productivity growth must take place in a

given country context. Even within a single country, obstacles often differ by

region. A survey of Russian firms indicated that there is no single region with

an ideal investment climate, but showed considerable regional variation in the

barriers to entrepreneurship. In Smolensk, for example, businesses have fewer

problems with excessive inspections but more problems with license and certi-

fications, whereas the opposite is true in Moscow City. Different countries and

regions face different constraints and problems, and the institutional and gov-

ernance responses to the challenge of improving the investment climate thus

will also vary across countries. In this, as in other policy areas, there are com-

mon principles, but there should be no “one size that fits all”.

How can we gather information? A number of routes have proven to be fruitful:

• Consultation with relevant groups. Such consultations will usually involve

a strong element of the qualitative. This consultation should go beyond

chambers of commerce or other representatives of large firms and multi-

nationals to include diverse representatives of all firms, particularly farm-

ers and micro-entrepreneurs. It should avoid giving undue weight to lob-

byists and special pleading. The World Bank has been engaged in such

consultations in a number of forums, including the participatory Poverty

Reduction Strategy processes used in very poor countries.

• Learning through direct experience of the investment activities of the mul-

tilateral development banks (International Finance Corporation, EBRD).




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• Careful surveys of firms to identify constraints. These surveys are used to

make strong quantitative assessments of the investment climate. There are

now a number of systematic and structured surveys that are already prov-

ing their worth, and this approach will take on great importance in the fu-

ture. The existing surveys show that we can be empirically rigorous,

quantified, and structured in measuring key elements of the investment

climate. Let me draw on results from India, where the research department

(DEC) of the World Bank is collaborating with the Confederation of In-

dian Industry (CII) on firm-level surveys of the investment climate. For an

illustration of what can be learned through such surveys comes, we can

compare the investment climate in Maharashtra, an Indian state with a

population of 100 million, with that of Uttar Pradesh (UP), another state

with a population of 170 million. One measurable dimension of the in-

vestment climate is the number of visits that local authorities make to the

firm – and we find that these are twice as common in the survey in UP

than Maharashtra. It is unlikely that these visitations are constructive and

probable that they are predatory.

Another dimension is the availability and quality of infrastructure. In

UP, the power infrastructure is so weak that more than 90 percent of

firms have their own generator; the comparable figure for Maharashtra is

less than 50 percent. This discrepancy is one reason for the surprising

finding that Uttar Pradesh, although much poorer than Maharashtra, has

higher capital/labour ratios. We teach our students about the relationship

between capital intensity and factor prices, but in this case another factor

overturns the prediction that we would derive from standard microeco-

nomic theory – that UP, with its low wages, would be less capital-

intensive than Maharashtra.

From these surveys, we can build stylised facts that will serve as the basis

for further investigation. But we find already that those Indian states with

better investment climates are growing and reducing poverty more

quickly. These surveys provide a valuable and exciting basis for further

theoretical and empirical research.

3 Involving poor people in growth

The kind of research on the investment climate that I have described helps

shape public policy in responding to the challenge of promoting investment,

productivity, and growth. At the same time, the task of fighting poverty re-

quires that public policy also work to ensure that poor people can participate in




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growth. This second process, fundamentally intertwined with the first, is a sec-

ond crucial challenge for development-oriented public economics.

3.1 Growth, poverty, and dynamic public economics

First, let me review what we know about the relationship between growth and

the welfare of poor people. The cross-country evidence does not suggest that

higher growth reduces the income shares of poor people (see Dollar and Kraay,

2001; World Bank, 2002). Interestingly, the results seem to go different ways

in different continents. In Africa higher growth has been associated with

higher income shares for the lowest quintile, but in Latin America it has gone

the other way. Thus we cannot take for granted a given relationship between

growth and changes in income shares for poor people – whether it be up,

down, or no association. Economic structures matter. So too do government

policies in such areas as education, health, and social protection. There are

choices to be made and much can be done to involve poor people in a growth

strategy.

Key to ensuring that poor people are empowered to participate in growth is

making sure that they have the tools necessary to participate and that institu-

tional structures facilitate rather than prevent their participation. Crucial public

policy elements here include working to involve poor people in decision mak-

ing in the public sector, promoting participatory social organisations2, and en-

suring legal protection. These activities, together with education, health, and

social protection, can together provide the circumstances for real

empowerment and effective participation.

We have argued above that firm-level surveys, when they solicit information

on the obstacles that firms face in innovation, investment, and entrepreneur-

ship, can underpin policy on the investment climate and growth. Similarly,

household and individual surveys that ask about empowerment and participa-

tion, together with surveys of basic service providers (such as health centres

and schools) and of government units, can help us formulate public policy on

empowering and investing in poor people so that they can participate in the

process of growth. The World Bank has also been investing strongly in such

surveys; see, for example, the three volume of Voices of the Poor (Narayan et

al., 2000a; 2000b; 2002) and the work on providers that is under way for the

World Development Report 2004 on basic services. I would suggest that em-

pirical public economics going forward will and should have a strong focus on

2 Although Robert Michels is best known for pointing out the oligarchical tendencies in organi-zations, we might recall his starting point: "Organization is the weapon of the weak in their

struggle with the strong." (Michels,1962, Chapter 1)




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these three types of surveys – firms/investment climate, households, and serv-

ice providers/government units – just as the empirical work stimulated by the

theory of the 1970s focused on household expenditure surveys and aggregate

demand functions.

In assessing where we now stand in our understanding of the first pillar of the

investment climate, I suggested that the empirics were ahead of theory. On the

second pillar of empowering and investing in poor people, I would suggest that

the same ranking holds. In both cases, we are at the beginning of a long pro-

gram of research and, in my view, we have much further to go on both the em-

pirics and the theory of the second pillar than the first.3 I suspect that modern

theories of organisation and incentives may have quite a lot to tell us about

why some modes of service provision work better than others.

Although this research program is still in its early days, let me speculate that

there are lessons from static theoretical and empirical work that can be gener-

alised to the dynamic. We know that the expenditure side is key to static redis-

tribution in rich countries.4 I would expect that the same lessons would apply

to dynamic participation for developing countries.

Further, the dynamic approach leads to a perspective on distribution that sees

the individual as the object of welfare, and not just the family or household.

Education, for example, benefits the individual educated and will usually in-

crease future incomes. From this perspective we should, when thinking about

distributional issues, take account of benefits that accrue to individuals over

time and not simply those that accrue to households now. Again, this is a per-

spective on public economics that is dynamic.

The perspective here is not primarily about the static redistribution of income,

but about ensuring that the pie grows and that poor people both help drive and

benefit from the process. The lives and prospects of individuals and their

families can be transformed by:

• education and health care, which increase their employability and ability

to become successful entrepreneurs;

3 For a first fruit of that program see Narayan (2002). For an earlier collection of case studies,see Krishna et al. (1997).

4 An illustrative example is from the United Kingdom. An analysis conducted at the UK’s Officefor National Statistics (Lakin, 2001) shows the effectiveness of cash transfer policies in reduc-ing inequality. The results for 1999-2000 show that the Gini coefficient (a measure in inequal-ity) of market income for the UK is 0.53. If one adds the impact of cash transfers made by thegovernment, the gross income inequality Gini coefficient registers a much more equitable 0.38.If one takes this gross income measure and then considers the impact of the income taxes inplace in the UK, there is only a marginal further decline in the Gini coefficient to 0.35. Finally,adding in the impact of indirect taxes pushes the Gini coefficient back up to 0.40. The simpleconclusion is that the net public sector impact is strongly redistributive, but the redistributionoccurs primarily on the expenditure side.




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• social protection, which allows them to take the risks that participation in

a dynamic market economy entails – the dynamic perspective on social

protection is as a springboard whereas the static perspective sees it as a so-

cial safety net;

• social organisation and empowerment through the legal system, which

improve the chances that their voices will be heard, that they can use their

assets, and that they will not be cheated or excluded.

It might be noted that these dynamic perspectives do not exclude, contradict,

or reject the standard arguments concerning taxation for education, health, and

redistribution. They build on them.

3.2 What can we do to promote the involvement of poor people in growth?

From our analysis of how poor people can get involved in growth, we find

some fairly direct public policy lessons or approaches. The challenge of em-

powering and investing in poor people is, in large measure, the challenge of

ensuring effective and efficient creation, availability, and delivery of basic

services. This is the topic of the World Development Report that will come out

in September 2003. In responding to the challenge, countries need to focus on

both the level of resources devoted to basic services and the efficiency with

which they are used. Just as with work on the investment climate, we are

learning how to use both qualitative and quantitative information to improve

the creation and delivery of basic services:

• Quantitatively, it is important to gather information about whether serv-

ices are actually reaching poor people, and in what quality – e.g., do peo-

ple have access to clean water, are children being immunized, are teachers

showing up at schools and doctors at clinics, do the schools have books

and computers, and do the clinics have drugs and functioning equipment?

For this reason, as I noted earlier, we are launching basic service delivery

surveys that are analogous to the investment climate surveys. Some of the

results of these surveys will form a key foundation for the World Devel-

opment Report of next year.

• Qualitatively, we must work to ensure that citizens’, consumers’, and par-

ents’ groups have a chance to make their voices heard. One challenge, for

example, is to encourage teachers to attend school; teachers show up for

work more when parents are involved in the governance of schools (as we

have seen from the District Primary Education Programme in India and the

EDUCO program in El Salvador). We have also seen the power of infor-

mation, for example in the Uganda expenditure tracking project that in-




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volved publishing the amounts of funds supposedly distributed from the

Government to the school districts (see Reinikka, 2001). In this case, in-

creasing the transparency of transfer of public funds yielded a dramatic in-

crease in the fraction that actually arrived, from an average of 13 percent

to about 90 percent over just a few years. We should not assume that these

examples operate solely through the greater monitoring and reward-

oriented motivation that might come from greater participation by benefi-

ciaries and their representatives. There is likely, for example, to be much

greater job satisfaction and self-esteem if teachers see parents as construc-

tively involved (see Tendler, 1997, for examples of successful programs

that emphasised the commitment and dedication of service workers).

While there is no doubt that the manner in which we use resources is just as

important as the quantity of resources, it is indisputable that public health,

hospitals, clinics, schools, and social protection require substantial resources,

however well those resources are used. For these reasons, tax revenue is fun-

damental. A society that is unable to raise revenue is unlikely to enjoy strong

and sustained growth or be able to ensure that poor people can participate.

Health and education outcomes are not determined wholly or even largely by

activities in those sectors. Health depends strongly on income and education,

particularly of mothers. Similarly, children often cannot get to school without

transport and infrastructure. Public policy in these areas of empowerment is

therefore much deeper and more complex than would be suggested by simple

approaches to resources applied and incentives used in health and education.

4 Where does this perspective of entrepreneurship and learning

take us in public economics?

As an illustration of where this approach to development can lead us, the fol-

lowing five examples show how this more dynamic approach to development

issues and public policy pushes us beyond the simple story. All five examples

are concerned with the endogeneity of innovations, behaviour, and institutions.

4.1 Returns to scale

Many economists have looked at agricultural production functions from the per-

spective of productivity (usually expressed in terms of output per acre) in small

farms versus productivity in big farms. Such analyses have underpinned discus-

sions of technology policy, land reform, and agricultural taxation. But the policy

implications for productivity concerning small versus large involve much more




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than issues of returns to scale as seen from static production functions. Dynamic

issues concerning innovation are also central, as examples in Latin America and

Eastern Europe make clear. Latifundia economies and soviet-style communism

are two examples where seeking higher productivity through returns to scale (in

one case through a market structure, in the other through a command economy)

had the effect of killing the long-term developmental effects for most partici-

pants. Short-term efficiency, often distorted by entrenched vested interests, was

pursued in a way that damaged long-term development and the empowerment of

people to create and innovate. Nicholas Kaldor was fond of emphasising that

Marx had fully understood increasing returns to scale and frequently quoted

Marx’s description of competition amongst capitalists for lower costs via scale

“Accumulate, accumulate; that is Moses and the Prophets” (Vol. I of Kapital).

But accumulating to exploit scale with one product may foreclose on innovation

for the next generation of products. As Schumpeter put it, “new combinations

are, as a rule, embodied… in new firms which generally do not arise out of the

old ones but start producing beside them; …in general, it is not the owner of

stage-coaches who builds railways.” (1934, 66)

Work that offers individuals and firms no room for initiative, learning, and

growth – for example, because of excessive specialisation in the pursuit of

static returns to scale − can have effects on human development and entrepre-

neurship that are profoundly disempowering. Adam Smith recognised clearly

the potentially deadening effect of repetitive factory work directed by others.

Thomas Jefferson had a similar perspective, with his vision of small farmers

and businessmen as providing a constant revitalising effect, which he con-

trasted with the static efficiency of big combines. A more recent and very im-

portant example lies in the dynamism of Chinese township and village enter-

prises (TVEs). These were much more dynamic and creative than the mono-

lithic state-owned enterprises (SOEs), which became a heavy burden on the

economy. Deng Xiaoping knew that an entrepreneurial force was being liber-

ated when TVEs were permitted, but as he himself later said, the creativity and

dynamism that emerged was a surprise to the leadership. Consider this 1987

quote from Deng Xiaoping:

Generally speaking, our rural reforms have proceeded very fast, and

farmers have been enthusiastic. What took us completely by surprise was

the development of township and rural industries. All sorts of small en-

terprises boomed in the countryside, as if a strange army had appeared

suddenly from nowhere. This is not the achievement of our central gov-

ernment. Every year, township and village enterprises achieve 20 percent

growth. This was not something I had thought about. Nor had the other

comrades. It surprised us. (People’s Daily, 13 June 1987, cited in Becker,

2000, p. 68).




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Kibbutzim and moshavim are examples in Israel that, in their time, showed

how to combine some scale with empowerment – using the special “social

capital” of a historical movement.

All these examples embody vital dynamics, learning, and creative forces. Any

policy towards development, industrial structure, and regulation that does not

take such forces into account risks being profoundly misleading.

4.2 Specialisation with gains from trade

In considering the effects of specialisation, the contrasts between China and

Soviet Union are instructive. The Soviet Union pursued gargantuan, highly

specialised plants. This was partly due to misplaced confidence in static re-

turns to scale, but also partly as a means of economic and political control:

highly specialised units and regions were all “held hostage” to each other and

could be controlled by Stalin’s central command. China, by contrast, aimed for

broad regional self-sufficiency and capability.

Mao's more decentralised and generalist approach built on Chinese history. It

placed a strong emphasis on regional self-reliance so that each region learned

to do many things – albeit not always efficiently. When the freeing of the

economy came later, China reaped the gains from specialisation and trade be-

tween regions. The availability of goods and skills locally allowed, for exam-

ple, the entrepreneurial cabinet maker to find tools nearby so that his nascent

entrepreneurship had a chance of getting off the ground. It would, of course, be

quite wrong to suggest that Mao planned it all this way. The market reforms of

Deng had to wait for Mao’s death. But the difference between the economic

structures that emerged from the Mao and Stalinist strategies here is very im-

portant in understanding the subsequent development of the very different

Chinese and Russian transitions from command to market economy. Stalin’s

model of the Soviet Union was of early hyper-specialisation, built upon an

ideal of static increasing returns to scale. It sacrificed the longer-term dynam-

ics and left a legacy of rigidity and fragility.

A policy lesson here is to seek flexibility and adaptability. Do not try to pick a

single winner early on; do not force over-focus. Try to create conditions for

learning where entrepreneurs can not only act and move but are led to seek out

potential areas of advantage and growth across a broad spectrum of economic

activity.




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4.3 Growth and inequality

Growth with large inequality can suppress the potential for future growth. Ini-

tial winners can use their influence with the government to “remove the lad-

der” – that is, to limit competition from other elements of society. Over the

long run, such measures can strangle growth. Three historical examples illus-

trate:

• Acemoglu et al. (2000; 2001) note that in the 19th

century, both North and

South America had large tracts of land and raw materials and were con-

quered and settled by Europeans. These authors argue that the endogeneity

of institutions is crucial to understanding the divergence in subsequent de-

velopment of the two regions. Institutions and growth have a two-way re-

lationship that can create a kind of dynamic increasing returns. An im-

provement in investment climate leads to more small and medium firms,

creating a constituency for a further improvement in the investment cli-

mate. This is a description of key aspects of the North American story. In

South America, with much greater inequality, powerful vested interests

captured the state and were therefore able to restrict competition and inno-

vation.

• A further example comes from the USA in the first part of the 20th

cen-

tury. The North American “robber barons” at the turn of the century were

similarly motivated to restrict and exploit, but they were eventually de-

feated by more progressive movements, for example through the anti-trust

legislation of that period.

• Finally, one interpretation of what happened in Russia in the 1990s is that

the oligarchs first grabbed their positions and then tried to consolidate and

protect their winnings (some would say “loot”), most notably by limiting

the development of a broad economy of independent small and medium-

sized firms.

4.4 Internalising externalities

One part of the static theory of externalities points to combining units that ex-

hibit mutual externalities into a big unit where all the interactions are, in the-

ory, taken into account. But such overlayered and powerful entities are likely

to stifle innovation. Hirschman noted that while innovation might cause losses

for some, “internalization is likely to result in an overestimate of the prospec-

tive losses” (1961, p. 61).




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Thus one is more likely to get innovations that will end up benefiting the many

when there is multi-centered competition in either the economic or political

sphere than when there is internalisation and then centralised project selection

(e.g., compare Renaissance Europe and China). It is much more likely that an

appropriate public sector response to externalities lies in trying to regulate and

tax in a way that allows different entities to innovate and compete, while at the

same time ensuring that they pay for damages inflicted on others or are regu-

lated to prevent them from inflicting damage.

4.5 Environment and sustainability

Related issues arise when we look at the environment and sustainability. There

are those who appear to argue that the only way to live in harmony with the

environment is to restrain growth. But that is unlikely to be a promising ap-

proach. Furthermore, it is probably also a mistake to see the issue as (simple)

sustainability, and it is a mistake made by much of growth theory, in terms of

long-run equilibrium or steady-state growth. It is better to see sustainability in

terms of the challenge of creating new opportunities, anticipating and re-

sponding to problems, and innovating as circumstances change. In many

structures, the incentives for adaptation are distorted, in that they take inade-

quate account of the long-term and destructive effects of many actions on the

environment. The right reaction is not to restrict growth and change but to re-

structure incentives through taxation, regulation, and the promotion of appro-

priate institutions. In this way we can try to foster the kind of learning and

searching that finds ways of growing and changing that do not damage, or in-

deed can overcome damage, to the environment. This approach to

sustainability lies at the heart of the World Development Report 2003 (World

Bank, 2003).

In cases where current trends are very harmful, then the appropriate response

may involve strong enforcement actions or very high taxes. Such interventions

would have to be guided by an understanding of how people learn. For exam-

ple, there was little reaction in terms of technology to the first oil price shock

of the early 1970s. However, the second oil price shock, in the late 1970s, led

to an explosion of technological research and innovation in the direction of

more efficient energy use, particularly in Europe but also in the United States.

People learn from big changes, and perhaps learn more when they see more

than one occurrence. There may be lessons for dynamic tax policy here.




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5 Some lessons and conclusions

Let me conclude with some lessons for the dynamic political economy of re-

form that run through the examples just presented. They can be presented in

terms of two quotes from very distinguished and thoughtful writers on these

issues.

… it is the nature of most innovations that its beneficiaries are anony-

mous, inarticulate, and unaware of the benefits-to-accrue (they include

among others the consumers that are yet unborn), while those who stand

to lose from the innovation are highly vocal vested interests.

That was Albert Hirschman over 40 years ago (1961, p. 61).

It must be considered that there is nothing more difficult to carry out, nor

more doubtful of success, nor more dangerous to handle, than to initiate a

new order of things. For the reformer has enemies in all those who profit

by the old order, and only lukewarm defenders in all those who would

profit by the new order. Thus it arises that on every opportunity for at-

tacking the reformer, his opponents do so with the zeal of partisans, the

others only defend him half-heartedly, so that between them he runs

great danger.

That was Machiavelli about 500 years ago (1940 [1513], Chapter 6).

The dynamic notions of public economics I have tried to sketch here not only

provide a way forward economically, but also have political advantages, which

take into account the difficulties highlighted by Hirschman and Machiavelli.

Static redistribution, for example, is more difficult to sell politically and to

implement in the face of entrenched interests than is the notion that all children

should have an education that allows them to participate in the process of

growth. As Eitan Berglas recognised very well, our arguments have not only to

be coherent and logically tight; we must be able to frame them in a way that is

politically persuasive.

The approach to public policy proposed here is first to ask what drives im-

proving living standards, particularly of poor people. We then ask how to in-

fluence these drivers. The drivers that we identified as twin pillars of pro-poor

growth were, first, the creation of an investment climate for entrepreneurship,

investment, and growth and, second, the empowerment of and investment in

poor people, so that they can participate in the growth process.

This perspective led us into the details of what the investment climate and

empowerment mean, and how to investigate them both empirically and theo-

retically in a way that illuminates policy. I argued that empirical work is mov-

ing quickly and the theory less so. From the conceptual perspective, what I am




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suggesting is that we introduce the spirit of the Boiteux-Samuelson-Diamond-

Mirrlees and Berglas public-policy approaches into models that embody an

approach to growth based on the insights of Hirschman and Schumpeter. The

theoretical side will involve a bundle of complementary approaches, not just

one. I believe that much of this conceptual development is already happening

in the profession that there is no greater task before us than building a public

economics that will promote growth, development, and poverty reduction

worldwide.

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